Why are some economists sceptical about demonetisation?

More than a fortnight since the demonetisation but the debate rages on - has this been a bold and historical move to destroy black money or a colossal misstep that has put millions of Indians in deep trouble? The government has given itself a pat on the back with the Prime Minister quoting results from what many have said is a highly biased survey through a mobile app.

Currency in circulation accounted for 80% of the reserve money in India on 11 November. Some 86% of this currency in circulation was in notes of Rs500 and Rs1,000. So, the withdrawn notes are around 69% of the monetary base (and not the entire base as some have written).

Rajadhyaksha remains hopeful that the move could lead to a positive change as it has forced many into a behavioural shift towards bank deposits which could in turn lead to an unexpected expansion in money supply, and perhaps provide a cushion against the reduction in the monetary base.

Vivek Dehejia, Professor of Economics at the Carleton University in Ottawa, Canada, also believes that any reduction in the monetary base can be effectively countered by simply circulating more money into the market. The BBC quotes him as saying -

India now operates under a monetary policy regime known as inflation targeting. If a portion of the stock of currency in circulation, consisting of currency and demand deposits gets 'burned', metaphorically or literally, the Reserve Bank of India, the central bank, can in principle fully offset this through what economists call 'open market operations

Prabhat Patnaik , economist and professor emeritus at Jawaharlal Nehru University in New Delhi feels that the demonetisation move has caused great inconvenience to the people and is not likely to yield the desired benefits. In this interview in The Wire he explains very simply that there is a misconception about how black money is circulated in the economy.

This move betrays a lack of understanding of capitalism in the government. Typically, what happens in capitalism in a situation like this is that there would be a new business opening up about how to change old currency notes into new ones. This is what Schumpeter called innovation – and in capitalism that is forever happening. A whole range of people would come up who will say you give us Rs 1000 and we will give you Rs 800 or 700 or whatever. Consequently, instead of curbing black business it will actually give rise to the proliferation of black business.

He goes on to say that it a tax administration which is honest and unbiased is needed to investigate leads, be it locally or in cases of foreign holdings, to recover black money.

Lawrence.H.Summers and Natasha Sarin, senior economists from Harvard also feel that the move is ill conceived. Scroll carried their views on the issue. Calling Prime Minister Modi’s announcement as a historically unprecedented move, Summers and Sarin point out demonetisation of currency which is widely used by ordinary people, overnight, violates the principles of a free society causing great suffering among innocent people.

We strongly suspect that those with the largest amount of ill-gotten gain do not hold their wealth in cash but instead have long since converted it into foreign exchange, gold, bitcoin or some other store of value. So it is petty fortunes, not the hugest and most problematic ones, which are being targeted. Without new measures to combat corruption, we doubt that this currency reform will have lasting benefits. Corruption will continue albeit with slightly different arrangements.

Although Summers has been in favour of abolishing high currency notes, he does not believe it is something to be done overnight and conclude -

We were not enthusiastic previously about the idea of withdrawing existing notes from circulation because we judged the costs to exceed the benefits. The ongoing chaos in India and the resulting loss of trust in government fortify us in this judgement.

the vast bulk of physical currency is held in the underground economy, fuelling tax evasion and crime of all sorts. Moreover, most of this cash is held in the form of large denomination notes such as the US $100 that are increasingly unimportant in legal, tax-compliant transactions. Ninety-five percent of Americans never hold $100s, yet for every man, woman and child there are 34 of them. Paper currency is also a key driver of illegal immigration and corruption.

However, he remains sceptical about the certainty of long term benefits, especially given the over- night phase out of frequently used currency. The last time such a sudden move was announced was during World War II in Europe. Rogoff instead advocates a gradual phase out of high value notes. He also points out -

the phase out of large notes is golden opportunity to advance financial inclusion, in the first instance by giving low income individuals access to free basic debt accounts. The government could use these accounts to make transfers, which would in turn be a major cost saving measure. But in the US, only 8% of the population is unbanked. In Colombia, the number is closer to 50% and, by some accounts; it is near 90% in India. Indeed, the 500 rupee note in India is like the $10 or $20 bill in the US and is widely used by all classes, so India’s manoeuvre is radically different than my plan

The Caravan carried this interview with senior economist Arun Kumar who has studied black money since the 1980s. Kumar says that there needs to be a distinction made between black income and black wealth and that to truly tackle the problem, black income generation must be addressed, as this is constantly in circulation, be it in the real estate market or elsewhere.

The black economy increased to 62 percent of the GDP [gross domestic product] by 2013, which is Rs 90 lakh crores [A 2014 National Institute of Public Finance and Policy report estimated that domestic black money was equal to 70 percent of the GDP—approximately 90 lakh crores].That’s why my estimate was that the black “money,” or cash component, immobilised is only 3 percent of the total black income generated this year.

On the need to curb counterfeit notes, Kumar says that only about 250 out of 1 million notes are fake according to the government’s own estimates. He says that if the government’s move was motivated by terrorists counterfeiting notes, they could very well do it again for new notes. He also agrees that investigation and prosecution, as carried out successfully in the US and UK is a better solution in dealing with black money.

My argument is that if the black economy is 62 percent of GDP that means it is systematic and systemic. It is not anecdotal. It’s not that one day you do it, the next day you don’t do it. Every act of corruption is a nexus between the corrupt politician, businessman, police and the bureaucracy or the executive. Unless you break this triad, the black-income generation will continue.

Kaushik Basu, a former economist in the World Bank and Chief Economic Adviser during the UPA regime, calls it bad economics.

GST was good economics; the demonetization is not. Its economics is complex & the collateral damage is likely to far outstrip the benefits.

Ordinary salaried people, retirees and small farmers who store their legitimate incomes in cash for future durable and rainy-day purchases, will not be able to change all their money for fear of harassment and not being able to explain how they got it. This can be very disruptive, increasing the costs of small business and trade and causing a drop in aggregate demand in the economy, thereby slowing growth.

Jean Dreze, an economist who was a member of the National Advisory Council likens the move to shooting the tyres of a racing car. Although he admits that it is very difficult to predict the long term effects on the economy, Dreze believes that it is too big a gamble. In this interview in The Economic Times, he says -

The initial economic shock, already visible, can easily have ripple effects over the next few months. For instance, delayed sowing of rabi crops today could affect the harvest months from now. With employers short of cash, labourers are likely to lose jobs. It is also important to remember that macroeconomic trends depend a lot on expectations. If the initial shock creates adverse expectations, the economy’s growth trajectory could be derailed.